Saudi budget points to low oil price

Saudi Arabia has just placed its budget for next year. News reports have indicated that it is showing a gaping hole in the Saudi government’s finances. It has a budget deficit of $100 billion. It is drastically cutting down subsidies on fuel, electricity and water. It is imposing VAT on commodities, including on tobacco. Suffice to say, Saudi Arabia is showing the strains of falling oil prices. There are fears that it could remain that way.

As the year draws to a close, the most frequently asked question is: “what will be the price of oil in 2016”. There are diametrically opposite views on the trends in oil prices, but as of now it looks as if the oil bears should win.

Why is that so important? Globally, oil prices will determine the size of the income redistribution. The trend in oil price would determine the size of income flows and it will, in turn, should dictate how much growth can really happen in the next year and the year after. How does it happen?

The drastic fall in oil prices from around $100 per barrel in early 2014 to just around $36 per barrel in December 2015 meant income redistribution to the tune of $2 trillion. That is, while the rich oil exporting countries, which were witnessing a tsunami of cash into their hands since 1973, are seeing falling revenues from oil sales.

Saudi Arabia, which has the largest reserves of oil in the world, depended on oil for its revenues. The cuts in its latest budget show what is happening. Budget receipts have gone down by 15 percent as the Saudi King announced the figures. Ever since oil prices started falling, it has been dipping into its foreign exchange reserves. It was around $724 billion in January 2015; this has touched $627 billion in early December. At the current rate, the International Monetary Fund (IMF) has predicted that Saudi reserves will vanish in five years.

The dip in oil price means that poor and middle-income countries have to pay less and that is a net gain to their income. Since these are poor countries, they spend most of their incomes. Such additional spending would help spur local demand and economic activity in this wide range of countries.

Anatole Kaletsky, a leading expert, has predicted oil price trade to range between $30 a barrel to $50 a barrel at its height in a recent article earlier this month. It is because oil price would now become like any other normal pricing behaviour. That is, the marginal cost of producing the last barrel of oil will determine its price in the market.

Until now, oil was not being priced on marginal cost, because the market was artificially controlled by Saudi Arabia and other members of the OPEC cartel. Now with more production than demand, the producers are coming round to marginal costs rather than an artificially high price through production control.

Why has this happened? The fundamental shift in oil market happened as the United States came out with huge production from their shale resources and that brought down USA off-take from the global market. Coincidentally, China slowed down, which had emerged as the biggest sucker of oil for its domestic economy.

Now that China is slowing down, rather fast as its growth rate is set to plummet to around 6 percent this year from a target of 7.5 percent, Chinese off-take is falling. Additionally, green lobbies’ are mounting pressure to cut down fossil fuel consumption.

The rough and ready estimates put the daily excess production of oil at over 1 million barrels per day and there is no prospect of that surplus evaporating over time. The oil producing countries realise that to maintain their income levels, they will have to go on pumping more oil and not cut back production. At least, Saudi Arabia has come round to that point of view and hence it is not cutting down its production.

The new threat to oil prices is again from another country which has the second largest reserves in the Middle East, Iran. The country has for a decade been kept outside global oil markets by western sanctions and its oil resources were also neglected. Hence, until now its production capacity had also degenerated. These capacities are being resurrected and fresh production is expected from Iran which will enter the global oil market.

It will, of course, be inescapable not to notice the oil bulls. Jim O-Neill, the former Goldman Sachs assets head, who has been following the oil scenario for as long as his professional life, predicts oil prices to rise. He had earlier predicted a $100 a barrel price when prices were just around half that level. O’Neill had last forecast oil prices to rebound.

It appears though that technology and innovation should hold the key to oil’s future. It looks as though technology, at last, is making it possible to shift over to alternative energy sources. According to reports, solar power costs are fast coming down and are already within competitive range of fossil fuels.

The abundance of supplies and redundancy of fossil fuels is giving rise to a new theory as well — the theory of “stranded assets”. It is believed that there is a good part of known and proven oil reserves that will never be pumped up. These “stranded assets”, which are currently shown in the balance sheets of major oil-producing companies, and have been used for financial engineering, would be worthless and this will impact the financial sector. Mark Coney, governor, Bank of England had referred to this fact recently.